Leiden Law Blog

The Shadow Banking Conundrum

The Global Financial Crisis (“GFC”) was arguably the worst economic disaster since the Great Depression, and the shadow banking sector was at the very epicentre. The crisis exposed significant fault lines within the global financial system and the cost imposed on the economy as a whole was in many cases catastrophic.

The shadow banking sector now accounts for a significant part of the financial system, and the net credit growth of the economy since the GFC has come from the shadow banking sector rather than traditional banking channels. Such impressive growth undoubtedly highlights the strength of the shadow banking sector and the consequent benefits it can bring to the economy. It does however also pose risk, and given that the shadow sector is not as tightly regulated as its traditional counterpart, it could become a serious cause of systemic concern.

However, in an effort to bring concerns to the public domain, the Financial Stability Board (“FSB”) publish their annual shadow banking report, which seeks to highlight new global trends of systemic concern and, as a consequence, any new vulnerabilities that may be lurking within shadow banking.

What is shadow banking?

‘Shadow banking’ has proved to be something of an elusive term. Although the term fails to impart much meaning, it successfully manages to convey the impression that, whatever it is, it is a sector of dubious legality with negative connotations. One could therefore be led to believe that shadow banking is part of some sort of a shadowy criminal banking syndicate. However, this statement is far from the truth. Shadow banking is neither shadowy nor illegal. It is a sector that operates within the legal perimeter, yet outside the confines of prudential banking regulation.

Under the spotlight of prudential regulation, traditional sector banks in the EU require a banking licence to operate and carry out the regulated activity of accepting deposits from the public. One example is you and I depositing our monthly wages with ING, ABN Amro and the likes. In this regard, we, as depositors, are insured up to €100,000 in the form of the European Deposit Guarantee Scheme Regulation (“EDGS”). In addition, traditional sector banks are also subject to the capital requirement regime imposed by Basel III. This means that at all times banks must maintain a minimum capital ratio of 8%. The ultimate aim is to ensure that banks remain solvent to prevent, for example, another Northern Rock bank run.

However, shadow banking is not subject to any of the aforementioned regulation. This is because the shadow sector does not have depositors. Instead, it has investors, who themselves take on the burden of risk. Given the size of the transactions typically involved in shadow banking, which will very quickly exceed the levels protected under the EDGS, the use of collateral and margin to hedge default risk are commonplace. Collateral is a safety net implying that, should there be default, the collateral can quickly be liquidated to make good on the promise. Margin is in place to hedge the risk on the collateral. The use of collateral and margin act as the functional equivalent to the EDGS found in the traditional sector, but on a much bigger scale.

Shadow banking is, therefore, a market based finance system that has its roots in the money markets. The essence of shadow banking is that it is a system that provides an alternative source of funding to traditional banking channels; but it does so under minimal regulatory oversight and on a more cost efficient basis. Essentially it is a sector that circumvents the costly and burdensome rules.

The ghost of the crisis still to come!

From the period of 1970-2016 there have been over 200 worldwide banking crises of varying degrees of severity. It is, therefore, not an unsurprising argument that the next crisis is imminent. This argument becomes particularly acute when we discover that the use of collateral within the shadow banking system has been a key driver for financial instability in recent times. Within the shadow banking system, the value of the collateral can very quickly drop. In this situation, the margin function can only absorb so much loss before more collateral will be requested to cover the value of the loan. Essentially, the borrower (collateral giver) must post more collateral to ensure that the lender (collateral taker) will not be worse off. However, if the collateral value keeps dropping, the borrower will quickly face financial problems as he runs out of options to post more collateral. Given that the issue of both collateral and margin remain unregulated, such a situation will lead to a devastating liquidity spiral thereby creating a domino-like chain of events within the financial system that may potentially be the catalyst for the next crisis.

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